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Wait and watch won't work

Dec 27, 2013

The difficulty is that monetary policy action is already delayed; further delay only makes future action that much more difficult.

On December 18, 2013, RBI Governor Raghuram Rajan set out the rationale of his wait and watch monetary policy. The press release, as also Rajan's oral presentation to the media, reflected deft handling of the subject.

Given the strong policy preference of the powers that be to keep interest rates low and industry's natural preference for low interest rates, the policy predictably earned loud applause from government, bankers, industry, analysts and the media. There have been few critics and mainstream thinking is to dismiss the criticisms.

The 20 years before the global financial crisis of 2008 were the glorious days of central banking; economist Paul Volcker talked about the ultimate "triumph of central banking".

The 2008 crisis changed all this. In countries like India where the government was already playing an overbearing role, the subjugation of the central bank was complete and government dominance became explicit and brazen.

Making sense

What does one make of the December 18, 2013 monetary policy? The Consumer Price Index (CPI) on a year-on-year basis has crossed 11 per cent on the official index; the 'true' rate is clearly much higher. Monetary policy works with a three to four quarters lag. Given these lags there was surely a case for strong, immediate monetary policy action.

The problem in India is that powerful forces work towards preventing monetary policy action by using political economy forces. This apart, the monetary policy statement is a masterly presentation on the case for a wait and watch approach.

As has often been articulated in these columns, the appropriate time for monetary policy action is well before the "upper turning point" of the cycle, which, in our case, was reached a long while back. The difficulty is that monetary policy action is already far too delayed and further delay only makes future action that much more difficult.

The current mood

There are the fashions of the time. It used to be argued that for monetary policy to be effective, it should be unanticipated. The prevailing view, however, is that one should not surprise markets. The markets had already anticipated an increase in policy interest rates but the RBI surprised them, albeit pleasantly, by not taking action.

The imperative need is to urgently curb inflation and this does not need any articulation. It is evident that large tracts of the population are suffering from the ill-effects of inflation. The persistent inflation has been one of the worst in four decades.

It is argued that food inflation is not amenable to monetary policy. This kind of argument blurs policy action.

When other wings of overall policy are constrained, it is necessary to use monetary policy even if it is an all-pervasive instrument.

It is not meaningful to argue that monetary policy has a lag and then wait and watch in the hope that next month's vital data on prices and real sector signals which would obviate the need for action. Indian policymakers find it hard to accept that generalised inflation is a monetary phenomenon which has to be handled firmly before it gets out of control.

Given the ground realities, the early months of 2014 will get progressively difficult and hence the RBI would be well advised to use every window of opportunity to tighten monetary policy.

Reading through the policy statement of December 18, one gets the impression that the calculated delay in hiking policy interest rates is with the hope that the need for policy action would disappear on its own.

With the way events are unfolding, there is a strong possibility of inflation accelerating in the ensuing months. Thus, there is need for a series of strong measures. The longer one waits, the greater the discomfort.

Measures such as revival of stalled investments would have little or no effect on the course of inflation in the ensuing months.

Thus, there is a case for early and sharp monetary policy action as inflation will get even more deeply entrenched in the system with the attendant social disruptions. Thus, lost ground has to be retrieved by off-policy monetary tightening.

The absence of monetary tightening has brought in its wake a clamour for lending rate reductions and to protect net interest margins. There are rumblings of deposit rate reductions in some maturity slabs. With negative rates of interest on deposits there is little incentive for savers to increase savings in financial assets. The inexorable shift to physical savings will only get reinforced.

It would appear churlish to dissent from the persuasion of the wait and watch monetary policy.

But as the French philosopher Voltaire said, "Everything is fine today, that is our illusion."

Please Note: This article was first published in The Hindu Business Line on December 26, 2013.

This column, Maverick View is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Freepress Journal, is titled Common Voice.

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